Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

© The McGraw−Hill^595

Companies, 2002

Because the assets of a firm are not directly affected by a capital restructuring, we

can examine the firm’s capital structure decision separately from its other activities. This

means that a firm can consider capital restructuring decisions in isolation from its in-

vestment decisions. In this chapter, then, we will ignore investment decisions and focus

on the long-term financing, or capital structure, question.

What we will see in this chapter is that capital structure decisions can have important

implications for the value of the firm and its cost of capital. We will also find that im-

portant elements of the capital structure decision are easy to identify, but precise mea-

sures of these elements are generally not obtainable. As a result, we are only able to give

an incomplete answer to the question of what the best capital structure might be for a

particular firm at a particular time.

THE CAPITAL STRUCTURE QUESTION

How should a firm go about choosing its debt-equity ratio? Here, as always, we assume

that the guiding principle is to choose the course of action that maximizes the value of a

share of stock. As we discuss next, however, when it comes to capital structure deci-

sions, this is essentially the same thing as maximizing the value of the whole firm, and,

for convenience, we will tend to frame our discussion in terms of firm value.

Firm Value and Stock Value: An Example

The following example illustrates that the capital structure that maximizes the value of

the firm is the one that financial managers should choose for the shareholders, so there

is no conflict in our goals. To begin, suppose the market value of the J. J. Sprint Com-

pany is $1,000. The company currently has no debt, and J. J. Sprint’s 100 shares sell for

$10 each. Further suppose that J. J. Sprint restructures itself by borrowing $500 and then

paying out the proceeds to shareholders as an extra dividend of $500/100 $5 per

share.

This restructuring will change the capital structure of the firm with no direct effect

on the firm’s assets. The immediate effect will be to increase debt and decrease equity.

However, what will be the final impact of the restructuring? Table 17.1 illustrates three

possible outcomes in addition to the original no-debt case. Notice that in Scenario II, the

value of the firm is unchanged at $1,000. In Scenario I, firm value rises to $1,250; it

falls by $250, to $750, in Scenario III. We haven’t yet said what might lead to these

changes. For now, we just take them as possible outcomes to illustrate a point.

Because our goal is to benefit the shareholders, we next examine, in Table 17.2, the

net payoffs to the shareholders in these scenarios. We see that, if the value of the firm

568 PART SIX Cost of Capital and Long-Term Financial Policy

17.1

TABLE 17.1

Possible Firm Values:

No Debt versus Debt

Plus Dividend

Debt plus Dividend

No Debt I II III

Debt $ 0 $ 500 $ 500 $500

Equity 1,000 750 500 250

Firm value $1,000 $1,250 $1,000 $750